Markets Crave Stimulus—Will the Fed Give Them Their Fix?

New evidence of sluggish U.S. jobs growth and dovish tones from Federal Reserve officials have pumped up expectations that the central bank could announce a new easing program after its meeting Wednesday and Thursday.

Ben Bernanke

The two-day Fed meeting is the big event in a week that includes some important economic data. Retail sales data Friday is likely to show consumers increased spending in August, but inflation data could show that some of what is being purchased is just higher priced gasoline.

In addition to easing from the Fed, traders are watching for other global stimulus that helped lift stocks in the past week. China, for instance, approved 60 infrastructure projects worth $157 billion, boosting global stocks and commodities Friday that could benefit from that spending.

Meanwhile, the European Central Bank’s announcement Thursday of a bond-purchase program aimed at lowering borrowing rates for cash-strapped countries helped give a lift to risk assets, and the focus now shifts to a German court ruling Wednesday on whether Europe’s ESM bailout fund is constitutional. (Read more:Is the ECB's New Plan Too Late to Save Greece?)

The weak U.S. August employment report Friday raised the odds that the Fed could move sooner rather than later on a new asset purchase program, or QE3. Wall Street’s Fed watchers, including some who did not expect QE, now see the possibility of a new open-ended program the Fed would use to purchase a mix of Treasurys and mortgage-backed securities. (Read more:Market Sees 'Helicopter Ben' Coming to the Rescue)

Just 96,000 jobswere created in August. “I do think this makes it more clear to them that they may want to do more,” said Dean Maki, chief U.S. economist at Barclays. “The fact we’re in the middle of an election season is a mild detriment but at the end of the day, they’re going to do what’s best for the economy.” Republican presidential candidate Mitt Romney and his running mate, Rep. Paul Ryan, (R-Wis.) have said they see no need for more Fed easing, and some in the markets say the easing could be construed as helping President Obama.

While there is no clear consensus the Fed will act this Thursday or some time later in the fall, there is a fairly uniform expectation that the Fed will extend the time frame for which it intends to keep interest rates near zero from 2014 to mid-2015 or later.

“I think they will push out the rate guidance next week,” said Ward McCarthy, financial economist at Jefferies. “The big question is what they do with the balance sheet. There’s very little doubt in my mind that they’re headed toward an open-ended QE.” McCarthy said the Fed could be flexible, calibrating its activity to the economy’s performance. QE expands the Fed balance sheet, and in theory drives investors into riskier assets while keeping rates low.

Whither Stocks

Stocks in the past week had the best performance since June. The Dow was up 1.7 percent to 13,306, the highest level since Dec. 28, 2007. The S&P 500 was up 2.2 percent for the week to 1437, the highest level since January, 2008, and the Nasdaq rose 2.3 percent to 3136, its best level since November, 2000.

Stocks had their best day of the week Thursday, after the ECB announcement. “After a huge day like yesterday, after a weak jobs report like we had, for the market to have a follow through like this, shows there’s demand for stocks,” said Scott Redler of T3Live.com, who trades the short term technicals. “Leading stocks continued to make new highs. The banks are up three days in a row, showing power.”

“I think we could pause in front of the Fed and digest a few days up here,” he said. Redler said he expects to see a lot of excitement around Apple in the coming week. The company is expected to announce its next generation i phone Wednesday. Redler, who owns Apple, says it could easily reach $700 a share based on the way it’s been trading. (Read more:Is Sept. 21 Really When the New iPhone Will Launch?)

Jack Ablin,CIO of Harris Private Bank said the market’s recent run has made him consider taking some profits, as his target for the year is 1450 on the S&P 500. “The closer we get the more tempted I am to watch the election with some dry powder,” he said.

“We normally like to stay in an extended market if there’s momentum,” he said. “For me to reduce risk is kind of running a little counter to our process … We threw a year-end target out there that we thought was reasonable and attainable. If we got there before year end, I’d rather, if I can, get my returns.”

There is concern the election seasonwill become increasingly volatile for stocks, and the market could get slammed in the fourth quarter if Congress does not act to resolve the "fiscal cliff." The fiscal cliff describes the hit the economy would take if Congress fails to stop the expiration of the Bush era tax cuts Dec. 31, or prevent a wave of automatic spending cuts that would take effect Jan. 1.

Binky Chadha, chief global strategist at Deutsche Bank, said he does not see that scenario as the most likely. Instead, the market may be acting as it historically has when a presidential election is a close call.

“I would say the election will play a role but it has not so far,” he said. “In all those close elections, what typically happens is the market is essentially flat September and October going into the election, and then you see a very robust five-percent increase between election day and year end.”

“We should get the typical five-percent pop,” he said. Chadha said the election could provide more “pop” if Republicans win the presidency or take control of the Senate from Democrats, as they are viewed as better for markets and could make clear moves to avoid the fiscal cliff.

Chadha said another plus for stocks is that the tail risk from Europe has lessened with the ECB action, and the stock market may now respond to the economic data, despite August’s poor jobs report. He said the market is already being helped by an increase in positive surprises in economic data.

In the past week, the data were mixed with improvement in jobless claims and the ISM nonmanufacturing survey (a gauge of the services sector), but weakness in the ISM manufacturing survey and the employment report. But the lowered forecasts from economists may now be easy for the economy to beat.

“We are actually at the cusp of getting positive surprises. What we’ve got so far is the less negative surprises,” he said. Stocks typically move in correlation with surprise indexes.

Econorama

Maki said he does not expect any of the data ahead of the Fed meeting to have a significant influence, but he is watching consumer-related sales and inflation data at the end of the week.

“What will be most interesting and most important for GDP will be the retail-sales report we got on Friday — and the CPI report is also Friday,” he said. “We believe CPI is going to show an 0.8 headline rise, which is going to be a kind of counterpoint to the (Fed) easing, when you get that kind of rise the next day. But that will be mostly gasoline which the Fed doesn’t focus on.” One criticism of QE is that it causes inflation, as investors buy commodities, and the dollar weakens.

Maki expects headline retail sales to show a 0.7 percent gain, in part from car sales and gasoline. Core should be up 0.3 percent. “We do believe consumer spending is picking up in the third quarter. We think GDP growth will as well,” he said. Maki expects 2 percent GDP for the second growth but it is tracking a little higher at 2.3 percent.

Even with low job growth, the consumer is showing signs of life. “We’re just not getting any liftoff. The unemployment rate has been stuck in the low 8-percent range,” he said. The unemployment rate fell in August to 8.1 percent from 8.3 percent but because more people dropped out of the workforce. “The Fed thinks the unemployment rate should be in the 5 to 5.5 percent range,” he said.